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Optimal Capital Structure for Personal Finance

By Braaak

This is a guest post by Braaak, former Portfolio Manager at a major mutual fund family. Currently Braaak provides insurance and other financial services to high net worth individuals and small- to medium-sized companies. He writes regularly and without regard for a consistent theme or style at “Up is Good, Down is Bad“. He hangs out in Central NJ with his wife of 17 years, 3 kids and one ugly water frog.

Do you know exactly why, even if you can afford it, it probably doesn’t make sense to pay off your 1st, and maybe even your 2nd mortgage?

The U.S. National Debt is almost universally decried by popular media as being a bad thing. Is it?

Do you know why, when companies need money, they sometimes issue stock and sometimes sell debt (bonds)?

What is Optimal Capital Structure?

Optimal Capital Structure (OCS) is the financing (getting money) mix that minimized the cost of capital and therefore maximizes the value of the entity that is using the capital (money) to do stuff. OCS also has important implications for personal finances and amateur investors alike.

In less formal terms, your family needs money to do stuff. Whether you are going to a movie or buying a house, you have two choices: you can pay cash or finance it via credit card, mortgage or bank loan. Neither choice is inherently bad. The mortgage choice is, in fact, obviously good in most cases.

Leveraging Debt

Let’s say you have a mortgage at 6%. If your marginal federal tax rate is 28% then the real after tax cost of your mortgage is 6% x (1-.28) = 4.32% before considering state taxes. You are borrowing long-term money at 4.3%. You should be able to invest long-term money in the financial markets and earn a return that is greater than 4.3%, so your mortgage is an important component of your OCS. And it frees up cash to do and buy other stuff.

The U.S. Government probably has too much debt currently but will always have some, for the right reasons. The U.S. has some assets – gold reserves, land etc., but its biggest asset is its ability to tax people and companies pretty much whatever it wants. The Government is responsible for taking care of the population – building roads, protecting the borders etc. By using some debt, the Gov’t can do these things when it sees fit without (a) waiting for the tax receipts to roll in or (b) printing money. Plus, The U.S. Gov’t can borrow more cheaply than most entities. If you buy a 10-year Treasury bond today, you are in effect lending the Government money for 10 years at 3.9%. Cheap. If the Gov’t prints more money, the dollar goes down and nobody goes to Europe.

If you follow me on the two above examples you probably get where I’m going when it comes to investing. All companies, and individuals, have a cost of capital. If they sell stock, investors expect a return, often a high return for higher-risk companies. If companies borrow money, the lender demands interest payments.

Companies are charged with maximizing shareholder value. If company XYZ’s equity (stock) investors expect the stock to go up 10%+ per year, and XYZ can borrow money at 6%, XYZ should have some debt. You don’t have to watch CNBC for long before you’ll here some market participant say, “blah, blah, the stock is cheap and the company has no debt” as if that is obviously good thing. It isn’t. If a company can borrow at attractive rates and interest payments are not so high that the company would have to refinance under worse terms in a downturn, some debt is good.

Debt is not a bad thing. In fact some debt, especially at favorable rates and reflecting available tax advantages, is a good thing.

About the author

Clever Dude


  • A compelling argument for having some debt. Like a friend pointed out to me, its always an advantage to pay tomorrow’s dollars as the time value of money would have made it worth a little less.

  • Debt is not a bad thing when people do use the borrowed money to generate more money with assets that appreciate (investment return > borrowing cost).

    Sadly, most consumers misuse debt by buying things they can’t afford.

  • It’s also important to match long-term debt to long-term investments, and short-term debt to short-term investments. Some investors have come to grief when they borrow short-term to make a long-term investment (eg. real estate). If they have trouble re-financing (at a similar rate, or even at all) then they may be forced to sell off a good long-term investment at a time that produces a loss.

  • You don`t need any debt to take advantage of leverage.
    You can use options instead. Your loss is limited and your gains might be nice.

  • If I had $100,000 in the bank and a 2nd mortgage of $100,000 at 6%, I may only pay 4% based on my tax bracket. So that’s $4,000 a year to pay this debt (simplified). When are you better off paying it off? When you do NOT have a 4% or greater investment with that money. Other than that you are simply paying for the privilege to be in debt. The argument works for businesses and countries but not necessarily individuals. Once you have your 6-month emergency buffer and other debts paid, go after the other bills. ALL debts ought to be erased when it comes to individuals.

  • debt is bad, period. why do you want to owe anyone anything? if you had no debt, you would not have to worry about paying off bills that could be easily avoided.

    our govt is in debt because we borrow money from foreign countries for stupid reasons, such as: giving billions a year in aid to israel, giving people stimulus checks so they can spend more foolishly, bailing out people who spent too much money on houses, etc. our money is fiat money, which means it is supported by nothing. this was done in 71 with the repeal of the bretton-woods act and our country has been in a downward spiral ever since, hence our economy is in horrible shape, so horrible that the canadian money trumps ours…yes, this is not a good thing at all. we have no gold backing our money, and our money is barely even worth the fiber it is printed on.

    when you have to borrow money just to try to make more money, you may as well just call a loan shark…at least they will just break a leg instead of taking away worldly possessions.

  • @Chris: Why did you buy your own house then? Did you pay cash (I know you didn’t). You’ll be paying money for something for the next 15-30 years for what? Just so you can paint the walls? You’re borrowing money from the bank in hopes that your house appreciates (at least to cover inflation), right? Because otherwise, you’re just throwing your money away with all the forthcoming repair work, taxes, interest, etc.

    I understand where you’re coming from with the rant, but I think you missed the main point of the article. It’s about leveraging debt to create wealth. It’s not for everyone, but you don’t have to be a major risk-taker to do it. I used 0% card offers to pay off our Malibu 4 years early. That’s avoiding paying more, but you can say I freed up money I wouldn’t otherwise have had because it would have went to paying interest.

  • I thing the point is that debt for a house is good because most of the time the house appreciates faster than the debt accrues. By the time you sell your house you can recover the principle plus interest.

    The second best debt is a 2nd mortgage because it is low interest since it is secured. Paying a 2nd mortgage of $25,000 at 5% over 5 years is better than a car payment of the same terms since you can deduct the interest paid.

    Of course, a better option is to save up the money for the car and buy it outright.

    My only debt is my 2nd mortgage and I want to pay it off in a year, or I can save the money and in a year have my options. If I need a car I may be better off securing it with my 2nd.

    The again I don’t want my house taken if I hit tough times. Take my car instead. It is all a matter of priorities. if I pay off my 2nd and get a car loan for a new car, so be it.

    The big point I think is awareness of debt. This country is hurting because we treat a credit card like cash and it is not. In fact today I got checks from my credit card companies “to use to pay bills.” Only 1.99% if I use these checks by July! Well if I pay cash I pay 0%. And then I’d go into debt, so using a check to pay a bill is robbing Peter to pay Paul. It is as if we are looking for the magic formula on how to have our toys, our money, and no debt all at once.

  • oooof on the walls…thats all i will say on that 🙂 the front and back decks need it though.

    and you are right, i had to take out a mortgage, unlike my parents who were able to pay straight cash for theirs.

    i was talking strictly govt borrowingwith my rant, which is what led us to our tispy-topsy economy, in turn, led us to our horrible personal money matters as is.

    i think robert’s last paragraph sums up what my views are on personal debt.

    i’ll give everyone a prime example:

    i got engaged, and was looking to get a ring, as is the custom. most places wanted to shove their store card down my throat. i had one place, honestly, refuse to sell me a ring because i didn’t want to use their card. they said it was only x.yz%…i said, or i can go to the atm, and just get the money and pay straight cash, the lady said, now why would you want to do that, and i replied, now why would i want to pay you more for the privledge of paying more for something when i can easily afford it now. trust me, i didn’t dress like i robbed someone for the money. (for a change)

    we can talk about how our govt is selling away our country one meter at a time the next time ya come back up north over some burgers…or steaks…

    (p.s. to all of you out there…invest in precious metals…it will help you 9 years from now)

  • Precious metals? I buy silver under $6 and sell over $10. Other than that it is too risky. And silver will double before gold does, so silver is the best investment there.

    But don’t use your credit card to buy metals!

    Buy Euros.

  • In your example of a 28% tax bracket, you still need to earn 6% before tax return to net 4.3%. This common fallacy is what the mortgage industry has been touting for years.

    One of your comments from Robert was that his “only debt is a 2nd mortgage”. He must mean, “besides my 1st mortgage, my only debt is…” Without a 1st, there is no 2nd.

    Being completely debt free is about living within your means, including your home.

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